Sequestration looming

Thu, 21/02/2013 - 13:21

Joanna Shatney (pictured), Head of US Large Cap Equities, gives her views on the upcoming sequestration in the US…

We are now just a few weeks away from sequester taking place in the US. Sequestration refers to the mandatory cuts in spending that go into effect March 1st in the US, directly impacting defense and Medicare spending (part of the Budget Control Act of August 2011). While some of these cuts are already partially reflected in analyst estimates, there are likely to be some downward revisions to GDP by Wall Street economists. We are watchful of these cuts, but remain optimistic that: growth prospects for corporate earnings could be stronger than consensus expects, government cuts will not translate into a significant headwind, and valuation of equities should capture investor interest.

Our base-case scenario is that sequestration comes into effect for at least several months and that headlines remain a primary worry for the remainder of the year. It is highly unlikely that Congress finds a resolution ahead of the March 1st deadline, raising the question of when the real deadline for resolution will be - and there is no definitive answer. The realm of possibilities ranges from a grand plan (unlikely) to an annual resolution of the required cuts. Republicans are focused on entitlement reform, while Democrats are looking for a measure of increased revenues (tax increases) and marginal entitlement cuts. Budget proposals are expected early next month and will incrementally add to the debate but, in our opinion, any really impactful decision making appears unlikely.

For investors, corporate earnings should be of greater concern. While GDP will be hit by these government spending changes, we see the multiplier effects as being more limited than the tax increases agreed to at the end of 2012 – meaning any effects from sequestration should be more manageable for corporate earnings. We are hopeful that an improving economy outside of government spending, higher corporate confidence, and a return to more normal international growth trends (aided by China) will lead to EPS growth of at least 5-7%. As the political debate continues over the next few months, bears are expecting a market pullback similar to what we experienced in 2010 and 2011. We are more hopeful that this becomes a consolidation rather than a dramatic pullback and we would be buyers of the dip.

Equity valuations remain compelling in the US. Bond markets are starting to show some slowdown after the hard run over the last few years. The S&P 500 is now up around 7% with mid-caps up closer to 9% since the beginning of the year. Bonds have shown more modest gains – high yield up 1.6%, investment grade corporates up approximately 0.5% and treasuries down marginally. Our argument for equities has been the extreme valuations that exist in the bond markets compared to the equity market. While this equity discount has existed for the past several years, a moderate growth scenario for earnings and low valuations should pull investors into equities.

In conclusion:

We expect that GDP will be negatively impacted by approximately 0.5% from sequestration over the next few months.

This will add to the 'wall of worry' for investors to climb in this economic recovery.

We see Fed policy as increasingly dovish – the dual mandate providing a cushion.

We see corporate earnings growth of at least 5% for large caps. Coupled with modest multiple expansion, there should be upside over the next 12 months.

We have avoided defence exposure in our portfolios and are conscious of the pressure in healthcare, choosing stories from this group which we think already largely reflect the downside.